Euro Area: Time to Tackle The Tough Challenges

July 19, 2018

The euro area economy is still in a good place. Growth remains strong, broad-based, and job-friendly, even if there are signs that it has peaked. At the same time, risks are rising, including escalating trade tensions and policy complacency among euro area countries. Rebuilding fiscal buffers and addressing structural issues to improve resilience, and building support for euro area reforms is now even more urgent, says the latest economic IMF health check of the euro area.

Related Links

Euro area growth appears to be leveling off from the very high levels of
late last year, but is projected to remain solid.

However, risks are mounting. Trade tensions have risen with the recent U.S.
imposition of tariffs on steel and aluminum imports.

Time is running out on the Brexit negotiations with the lack of progress
raising the risk of a disruptive exit.

Policy inaction and political shocks are important domestic risks, especially with regard to rebuilding fiscal buffers
in countries with high public debt and implementing structural reforms. Against this backdrop, strong policies
are needed to buttress the euro area’s resilience.

ECB should stay committed to low for long

Underlying inflation remains low, and is expected to converge only
gradually to the ECB’s objective. The European Central Bank’s (ECB)
commitment to keep policy rates at their current low levels, at least
through next summer, is therefore vital. As quantitative easing is wound
down, the importance of the ECB’s forward guidance on interest rates will
grow even stronger.

Much is needed at the national level

Despite strong growth, public debt loads have barely fallen in the
high-debt countries, leaving insufficient fiscal space to respond to the
next shock. High-debt countries should ramp up their fiscal efforts—
reigning in deficits and reducing debt—while conditions remain supportive.

In many countries, structural reforms must be stepped up to lift
productivity and create job opportunities. Large net creditor countries
with persistently excessive current account surpluses and ample fiscal
space need to increase public investment in infrastructure, education, and
innovation. This will lift potential growth and contribute to a necessary
external rebalancing.

Reforms to the architecture of the common currency area are long overdue

Now is also a good time to fill in the missing pieces of eurozone
architecture so that the region is prepared for future shocks.

Banking union

The recently completed Financial Sector Assessment Program (FSAP) for the euro area finds that euro area policymakers have made significant progress on this front. But more needs to be done.

Importantly, the lack of a common deposit insurance scheme and a shared fiscal
backstop for the Single Resolution Fund could put these achievements in jeopardy.
Completing the banking union will help weaken the links between banks and
sovereigns that was at the heart of much of the crisis.

To make it work,
all sides will need to show trust and accountability.

While substantial risk reduction has already been achieved, banks with
high-levels of non-performing loans should commit to aggressively clean-up
balance sheets. Banks can also use the current upswing to continue building
capital and ensure they have the ability to absorb any future losses.

Capital markets union

Progress on building a capital markets union is encouraging; for example,
the measures taken to help small firms raise financing across borders. But
further reforms are needed to
deliver a genuinely single and integrated capital market.

In the near term, it is critical to ensure that regulatory and supervisory
capacities are prepared for the influx of financial firms that will move to
continental Europe as a result of Brexit.

Over the medium term, there will need to be greater harmonization of
national insolvency regimes and securities regulations. Implementing all or
even some of these proposals would develop capital markets and stimulate
growth for the entire region..

Fiscal risk-sharing

The euro area relies too much on monetary policy to stabilize the economy
when hit by a shock. A recent IMF Staff Discussion Note proposes setting up
a central fiscal capacity (CFC) for macroeconomic stabilization. Such a CFC
would require countries to save in good times, by paying into the fund.
Then, in a downturn, countries would receive transfers to help them offset
budget shortfalls. The proposals cover strong safeguards, however, to
ensure that countries maintain prudent fiscal policies and that there are
no permanent cross-country transfers.